The USD Surge Is for Real

Last week's USD break higher has been confirmed by further gains this past week, while pullbacks have been exceptionally minimal. The speed and size of the move caught many in the market off guard, and while many analysts have already started with the "Too far, too fast" routine, I would argue that further direct USD gains are in store. Precisely because the USD rebound was so fast and large, many asset managers missed the move and have been anxiously waiting for some pullback on which to buy USD. The fact that the pullbacks of the last two weeks have been so minimal and so short-lived (rarely more than 4 hours) is evidence that institutional investors and asset managers are being forced to go to market and buy USD on strength, and sell EUR on weakness. Normally, that dynamic tends to create more instability-new positions are opened at disadvantageous price levels and are ripe to get whipsawed.

But the price action this week has remained especially persistent. For example, EUR/USD went into a consolidation between Tuesday's NY open and it lasted only until Thursday NY morning session (and barely amounted to 150 pips retracement, and that after a 700 pip decline in the prior 72 hours), when the move down resumed. Traders have come to expect greater consolidations and/or corrections after such large price shifts, and when they don't materialize, those traders miss the move again. So from a market dynamic perspective, I look for further direct USD gains as more investors are forced to reach higher to buy USD. Further, those who buy the "Too far, too fast" theory and short the buck are likely to provide additional buying interest as they capitulate and stop themselves out.

The primary level I'm watching in EUR/USD is the measured move objective from the double-top at 1.6020/40 which comes in between 1.4500/50. That level is a round-number, psychological support and also roughly corresponds to the start of the USD plunge earlier this year. Beyond there, I'm looking at 1.4300/20 lows from Dec. 2007 as the next likely point of stabilization. I think the sell zone in EUR/USD is now between 1.4900-1.5000. Everyone and their brother were looking to sell on a bounce back to 1.52/53, and that's another reason I think we'll see 1.43/45 before we ever see it back above 1.50.

Great Global Growth Slowdown Is Just Getting Started

The US economy dragged down global growth prospects starting in late 2007, and the ripples have spread out now to hit the rest of the G7. European growth contracted in Q2, as did Japan's. UK data continues to deteriorate and Q3 GDP there will likely be negative. Recent Canadian data also points to a recent erosion in the outlook north of the border. The G7 accounts for a bit more than half of global GDP, so when G7 growth turns down, the rest of the global economy will surely be impacted. Markets seem to have only just recently grasped the idea that global growth is slowing, and many are still discounting the risks to the global growth outlook, mainly on rationale that growth in emerging economies, led of course by the BRIC nations (Brazil, Russia, India, and China), would sustain global demand.

The BRICs account for around 13% of global GDP, so even if they manage to maintain growth rates, they're unlikely to prevent further slowing globally. Not to mention, much of the strength in emerging economies is due to exports. However, if the economies to which they export are contracting, what does that imply for the outlook to their exports and growth in general? Just two quick examples to illustrate: 1) Taiwan total exports dropped from +21.3% YoY in June to +8.0% YoY in July; 2) South Korean retail sales fell from +10.1% YoY in May to +6.8% in June. I realize both those numbers are positive, and strongly so from a G7 economy point of view, but it's the relative shift that I find alarming. Emerging economies are still bearing the brunt of higher food and energy prices, and one could argue that recent declines in commodities may offset slowing global growth. Still, the recent commodity price declines are minimal in relation to the amount of price increases over the last two years, and need to correct much more to stop being a drag.

Falling commodity prices have also contributed greatly to the resurgence in the USD, but that means other currencies have weakened. Since most commodities are priced in USD, lower commodity prices are partially offset by a stronger USD/weaker domestic currency. For example, WTI oil priced in USD is down about 24% from its peak, while the same oil priced in EUR is only down about 18%.

To tie this all together, the most developed economies are slowing due to oppressive increases in raw materials prices and a host of individual domestic issues (e.g. housing downturns and restrictive credit conditions).The slowdown in the G7 is increasingly reverberating in emerging economies, the ones that were supposed to stave off a global recession, and this is likely to be felt even more throughout the months ahead. Finally, slowing global growth is undermining demand for commodities, which is helping to boost the USD. While USD strength adds to the pressure on commodities, it also gives less relief to non-US economies, which will keep the USD in the limelight.
In short, the global slowdown is only just getting started.

Don't Bet Against the US Consumer

Despite massive headwinds from declining home prices, a stagnant credit market, and an absolute surge in gasoline prices at the pump, the US consumer has managed to hang in there. This resilience is behind the amazing winning streak for the US consumer, with the last quarterly decline in real personal consumption expenditures occurring all the way back in Q4 in 1991. Also stunning is how the consumer has managed to sock away roughly $70 billion of the stimulus checks while keeping consumption above water in both May and June (July data is due August 29). This cannot all be attributed to more rampant use of the credit card either, as the annual rate of revolving credit outstanding slowed to 4.9% in Q2, down from 6.8% in Q1, and 8.2% in Q4 of 2007. So it seems that the consumer balance sheet is in a state of very serious-and very speedy-repair.

The recent decline in oil prices and the deceleration of home price declines bode well for a resilient consumer spending environment as well. Oil has come crashing down towards the $112-110/bbl area in a matter of weeks. And while gasoline prices at the pump take a bit longer to react, if the historical relationship holds, this suggests average regular gasoline prices will be sitting near the $3.60 mark in about a week. This is roughly a $0.50 decline from the recent highs in mid-July. If we apply a well recognized formula that every penny decline at the pump creates an influx of $1.3 billion into US consumers' wallets, this is an additional $65 billion in consumer stimulus just as the tax rebates come to an end. While it is uncertain whether consumers will continue to hunker down and save or merely spend this newfound wealth unabashedly, we would be cautious about forecasts predicting the demise of this 70% chunk of the US economy. In our view, this potential for a fundamental improvement in the US economy, coupled with the continued deterioration in economies across the pond, augurs for a sustained USD rally into year-end and the first half of 2009.

Key Data and Events to Watch Next Week

The US data calendar is modestly busy in the week ahead, and the action kicks off with the National Association of Home Builders (NAHB) index on Monday. Tuesday is a busy one with producer prices, housing starts/permits, and Dallas Fed president Fisher speaking on the US economy. Thursday has the usual weekly jobless claims, the Philly Fed manufacturing index, and the index of leading economic indicators. Friday rounds out the week with Fed chairman Bernanke's speech at Jackson Hole. This has been a very important event in the past and will be watched closely by the markets.

The Euro zone has a few bits of top-tier data on tap as well. Monday starts it off with the Euro zone trade balance and the Bank of France's business sentiment indicator. On Tuesday we'll see the all important Euro zone and German ZEW surveys, along with German producer prices. Wednesday is PMI day, with the release of Euro zone, French, and German services and manufacturing PMIs all on tap. These should provide further evidence that the deterioration in Euro zone economies is continuing in earnest. Euro zone industrial new orders and current account statistics will round out the week on Friday.

The data calendar in the UK is rather light and starts with the Rightmove home price indicator on Sunday evening. The Bank of England's meeting minutes are set to be released on Wednesday, and will be closely watched, as the BOE did not release a press statement upon their latest decision to leave rates unchanged. That same day, the Confederation of British Industry releases their industrial trends survey of UK manufacturing as well. Retail sales data are on tap for Thursday, along with business investment data. Friday rounds out the week with the Q2 preliminary GDP announcement.

Japan's calendar is similarly light but important, with the Bank of Japan's rate decision the highlight on Tuesday. The market expects no change in rates from the current 0.50% target. Before that, we'll see the leading index and department store sales data on Monday. Wednesday has trade data, and Thursday rounds out the week with machine tool orders.

Canadian data will be very light, but starts off with wholesale sales data on Tuesday. Wednesday has the important retail sales report along with leading indicators. Consumer prices close out the week of data on Thursday.

Data is also light down under. New Zealand producer prices kick off the week on Monday. Tuesday has Australian imports data and the RBA minutes on tap.
Thursday ends the week for data with New Zealand credit card spending and Australian motor vehicle sales.